John Cochrane thinks we liberals who think higher minimum wages can do some good by offsetting monopsony power fail to grasp labor economics. He is citing some work by Jeffrey Clemens, Lisa B. Kahn, and Jonathan Meer. Alas his blog post screwed up the link to this interesting paper:
Compensation consists of a combination of cash and non-cash attributes, and depends on worker productivity. We also allow for the possibility of a bargaining wedge whereby the firm pays less in total compensation (cash and non-cash benefits) than a worker’s marginal product. When the minimum wage rises above the prevailing wage (cash payment) but below a worker’s marginal product, the firm will shift the mix of compensation towards cash and away from non-cash benefits, but will still find it worthwhile to employ the worker. This distortion can create losses to worker welfare which, if large enough, will push workers to prefer their outside option of nonwork. We also show that, in the presence of a bargaining wedge, the welfare effects of minimum wage increases are non-monotonic. In general, wage gains associated with increases in worker bargaining power will tend to improve welfare, while wage gains that are accommodated through reductions in non-cash benefits can reduce welfare.
In many ways, this dates to a 1980 paper by Walter Wessels (“The effect of minimum wages in the presence of fringe benefits: An expanded model,” Economic Inquiry), which the authors cite. Wessels assumed a perfectly competitive model where government interference lowered worker total compensation. Wessels published later papers, which alas the authors did not cite. In 1994, the Journal of Labor Research presented an extension of Wessels thinking that incorporated monopsony power entitled “Minimum wages and the wessels effect in a monopsony model” by J. Harold McClure:
I’m working on this:
United States of Imagination. Bottom 40% earners take 10 units of pay out of overall 100. Mid-59% take 70 units. Top 1% take 20 (we won’t be concerning ourselves with the 1% for now).
Bottom 40% spend 2 of their 10 units (20%) of pay on bottom 40% produced stuff. Mid-59% spend 7 of their 70 units (10%) of pay on bottom 40% produced stuff.
Scenario: bottom 40% double their wage price – adding 15% to costs of what they produce. Let’s say that only causes 10% loss of sales (likely because USI bottom labor costs are unreasonably low to start with – also because it makes the math a lot simpler).
Bottom 40% made stuff loses 1 unit of sales out of 10 from mid-59% purchasers. Doubled bottom 40% wages are reduced 10% by the 10% loss of sales – (doubled) 20 units minus 2 lost units leaves 18 units left. Extra 8 units add 1.6 units of sales – total sales 10.6 units (sales up .6) – and wages doubled!
Mid-59% wages reduced and spend proportionately less on mid-59% produced goods and services.
At this point we can bring the 1% back into our figuring. 100% of the time that academic or journalist progressives talk of confiscatory taxation, the next thing they say (100% of the time) is what government program that could pay for. 100% of the same time I always think instead of how those taxes could ultimately put more money in the pockets of the 59% to pay for higher consumer prices brought on by rebuild labor unions. Money’s fungible, I know; but just saying.
From Kevin Drum column: a 20% surtax on all income over $50 million would be the (constitutionally approved) equivalent because of a 2% wealth tax — because most people at that income level happen to have ten times their income as assets.
We could allow a proportional surtax on income, pegged to assets to be more fair. If the Supreme Court didn’t buy that we could forget about more fair.
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I’m looking to double the income — not just add 10% — to the bottom 40% of incomes — not just those on the minimum wage(s).
I haven’t read and shouldn’t comment, but I get the impression that Cochrane is making an argument about policy based on a model which “assumes”. This just won’t do in the 21st century. Only if there is empirical evidence that a higher minimum wage has a large effect on fringe benefits should we ask if this effect is efficient.
A model which assumes can’t tell us anything useful about the real world unless and until its testable implications have been tested and have passed the test.
I am guessing that the model also assumes there are no tax advantages of compensating with fringe benefits and therefore no distortion which would make the level other than optimal without a minimum wage.
I am guessing not reading, but I guess that the argument is nonsense. Using a model which is clearly not realistic on critical points to argue that the free market solution is best and that any new regulation is bad (this means that it is assumed that there are no other distortions including those from other state interventions like, you know, taxes).
I really shouldn’t have typed this comment.
Robert – I’m glad you wrote this comment. I did carefully read Meer’s paper which shows that the reduction in health care compensation was a fraction of the increase in wage compensation. That would not be the case in the competitive market version of what Wessels wrote but it would be explained by the monopsony version as noted in that 1994 paper, which obviously Cochrane has not read either.
I noted this over at Cochrane’s place as well as Henderson’s. Neither have bothered to acknowledge this critical point.
“Using a model which is clearly not realistic on critical points to argue that the free market solution is best and that any new regulation is bad (this means that it is assumed that there are no other distortions including those from other state interventions like, you know, taxes).”
Taxes and other state interventions are not the only distortion. My point has to do more with monopsony power, which of course in the Cochrane world cannot exist.